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restatement and internal control risks; thesevariables have become important in the post-SOXera.

The importance of risk mitigation by Big N firms(prior to the demise of Arthur Andersen there were

more than four so-called Big firms) is a themefound in earlier papers such as Krishnan andKrishnan (1997). A good example of this literaturestream is Shu (2000), which finds that auditorresignations are related to increases in clientslitigation risk (captured in variables such asinventory, receivables, size, stock volatility andwhether the firm is a technological firm, delistedfirm and received a qualified opinion). Shuconfirms these results by using an event studymethod: stock returns are negative for resignationsand related to changes in litigation risk. Shualso finds that resignations are motivated by

auditor-client fit issues: fit is determined byrelating the probability of being audited by a bigauditor to firm characteristics such as size,acquisitions and new financing. A key result fromShu (2000) that is relevant to our study is thefinding that discontinued firms switch to smallerauditors; furthermore, the greater the increase inlitigation risk, the greater the tendency to switch toa smaller auditing firm. Shu (2000) explains thatsmaller auditors do not risk as much reputationalcapital as larger auditors and also do nothave deep pockets that attract litigation. Thephenomenon of client switches from Big N firms tosmaller auditors was thus established even priorto Arthur Andersen and SOX. This implies thatwhile SOX might have accelerated downward

switches, the long-term post-SOX equilibriummight be characterized by a secular trend ofdownward switching albeit at a lower rate.

A recent study by Landsman, Nelson andRountree (2009) compares auditor switches (from

Big N firms) in the pre- and post-Enron eras. Sincethe post-Enron era is characterized by clients ofArthur Andersen seeking other (usually Big N)auditors, the resulting capacity constraint ishypothesized to change the sensitivity betweenswitches and the twin influencing factors of clientrisk (financial risk, audit risk and auditor businessrisk variables) and client misalignment (size,acquisitions, new financing and so on). Specifically,with the new pool of potential clients following theEnron scandal, Big N firms are perceived to lookmore closely at their current portfolios and pruneout certain clients not aligned with their needs.

This is the insufficient capacity hypothesis. In ananalysis of client switches from Big N to otherauditors, Landsman et al. (2009) show an increasein sensitivity to client misalignment but a decreasein sensitivity to client risk. These results largelysupport the insufficient capacity hypothesis.

Restatements in the post-SOX era

We now turn to a recently acknowledged measureof audit risk: restatements. To emphasize theprevalence and importance of restatements inthe post-SOX era we provide a simple count ofrestatements from the Audit Analytics restatementsdataset. According to Figure 1, the number ofrestatements peaked during 20052007 and is

Figure 1: Number of unique firm restatements by year for Second Tier clients versus non-Second Tier clients.Note: This figure represents the number of unique firm restatements by year for all Second Tier clients versusnon-Second Tier clients. Data source is Audit Analytics.

312 R. M. Dey and A. Robin

Int. J. Audit. 16: 308334 (2012) 2012 Blackwell Publishing Ltd


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double the number during 20022004. This is awell-known fact and has been reported in academicpapers as well as in industry commentary. The highfrequency of restatements triggered a number ofresearch studies inquiring into its causes and

consequences.Interestingly, much of the restatements literature

focuses on its consequences rather than its causes.An exception is Plumlee and Yohn (2010), whoanalyze corporate disclosures and outside newssources related to restatements to ascertain thecauses attributed to restatements. A key finding isthat a majority of restatements during 20032006are attributable to internal company errors. Theauthors state that this finding is consistent with theposition that internal reviews related to SOX areworking. This finding and conclusion appear tosupport the notion that restatements and ICW

flagged by various SOX sections are connected, asconfirmed by our own tests which are reportedlater in this paper.

A large number of studies report on variousconsequences of restatements. The basic conclusionfrom this literature is that restatements matterand that they often have adverse consequencesfor investors, managers, and directors. Specificfindings include: stock prices react negativelyto announcements of restatements (Palmrose,Richardson & Scholz, 2004); labor marketsimpose penalties on directors (Srinivasan, 2005),and managers (Desai, Hogan & Wilkins, 2006). A

particularly interesting stream of research, onerelevant to our work, connects restatements withinformation asymmetry as well as informationrisk. For example, Kravet and Shevlin (2010) findthat a restatement announcement increases the

factor loading on the discretionary information riskfactor and thus increases the cost of capital for afirm. Thus restatements coincide with reportingweakness and have adverse consequences for firmsand their stakeholders; this, in turn, supports theproposition that restatements increase client riskfor auditors. This connection between restatementsand risk for auditors is also supported by studieslinking restatements with auditor change, butmuch of this evidence is preliminary.9

Internal control weaknesses in the

post-SOX eraWe now turn to our next audit risk variable: ICW.Disclosures of ICW increased dramatically in thepost-SOX era (see Figure 2). Although SOX has twoimportant sections pertaining to internal controls,302 and 404, it does not elaborate on the meaningof internal controls. The prior literature on internalcontrols (e.g., Zhang, Zhou & Zhou, 2007) refersto the following definition provided by theCommittee of Sponsoring Organizations (COSO)of the Treadway Commission in their reportpublished in 1992 titled Internal Control Integrated Framework: it is a process, effected by

Figure 2:Number of internal control weaknesses (Section 404) by year for Second Tier clients versus non-SecondTier clients.Note: This figure represents the number of internal control weaknesses, specifically SOX Section 404, by year forall Second Tier clients versus non-Second Tier clients. Data source is Audit Analytics.

The Post-SOX Evolution of the Client Portfolio of the Second Tier: A Focus on Restatement and Internal Control Risk 313



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do, however, recognize the potentially reducedrelevance of the ICW variable (especially the onerelated to Section 404) in tests of hypothesis 2. Thisis because of the higher likelihood that clientsswitching from the Second Tier to smaller auditing

firms are small firms. As explained earlier, firmswith a market capitalization of less than $75 millionare deemed non-accelerated filers and are yet tobe required to comply with Section 404b. Therefore,even though our test variable does not distinguishbetween 404a (management report) and 404b(auditor report) because of the manner in whichthe data is reported in Audit Analytics, it mightoffer explanatory power concerning switchesfrom the Second Tier to smaller auditing firms.While the first two hypotheses are our main ones,we conduct further examination of new clientsversus continuing clients by examining resignation

and dismissal firms separately. This hypothesis isstated and explained below.

Hypothesis 3: Resignation firms (firms whoseprevious auditors resigned) will indicate a highersensitivity to auditing risks as measured by theprevalence and severity of restatements and ICWcompared to continuing firms of the Second Tier; incontrast, dismissal firms (firms who dismissed theirprevious auditors) will not show this highersensitivity.

The process by which firms change auditors iscomplex and it is usually difficult to definitivelystate whether a certain change is initiated by theclient firm or by its auditor. Nevertheless,

information is available in the Audit Analyticsdatabase that allows us to categorize changes intoresignations and dismissals. The former is morelikely to represent action initiated by auditing firmsand the latter is more likely to represent action by

client firms. Accordingly, the link between clientswitches and auditing risk variables (restatementsand ICW) is likely to be more pronounced in theresignation sample compared to the dismissalssample.13 This analysis, of course, is constrained bythe accuracy of Audit Analytics in categorizingresignations and dismissals, and, as such, theevidence could be considered tentative.

3. SAMPLE AND VARIABLES

We obtain our sample for the period 20042008 by

using the following steps. We use the AuditAnalytics Audit Opinions database to identify allfirms audited by Second Tier auditors (GrantThornton, BDO, McGladrey, and Crowe). We thenobtain relevant audit-related data from thefollowing Audit Analytics databases: AuditorChange, Disclosure Control, Internal Controls andRestatements. We then obtained financial data fromCompustat. Our final sample is made up of firmswith non-missing data.

Table 1 provides the number of clients servicedby the Second Tier firms each year during20042008. For each year, the table providesthe number of new clients in the current year(A), those continuing from the previous year

Table 1: New, continuing, and departing clients for Second Tier audit firms

2004 2005 2006 2007 2008 Total

New in current year 131 96 105 94 42621% 16% 17% 15% 17%

Continuing from prior year 497 514 506 519 203679% 84% 83% 85% 83%

Total during current year 607 628 610 611 613 2,456/2,462100% 100% 100% 100% 100%

Departing before next year 110 114 104 92 42018% 18% 17% 15% 17%

Continuing to next year 497 514 506 519 2,03682% 82% 83% 85% 83%

Note: New, continuing, and departing clients are determined using Compustat and Audit Analytics data, asdescribed in the text, and include only publicly traded client firms. New clients are defined as firms previouslyaudited by a non-Second Tier auditor and audited during the current year by a Second Tier auditor. Continuingclients are defined as those continuing with a Second Tier auditor from the prior year. Departing clients aredefined as those departing before the next fiscal year-end to a non-Second Tier auditor. Second Tier audit firmsinclude BDO Seidman; Crowe Horwath; Grant Thornton; and McGladrey & Pullen.




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(Bt-1), total clients during the current year(C = A + Bt-1 = D + Bt), those departing before nextyear (D) and clients continuing to next year (Bt).Since our data start from 2004, items A and B t-1 aremissing for 2004. Although the turnover rate isaround 20 percent, overall, the number of clientsappears to be stable at around 600 firms. Roughly20 percent of the overall client base departseach year and a similar number of new clients areacquired. Our main tests involve the comparisonof new clients with those continuing from theprevious year (that is, we compare A with Bt-1) anddeparting clients with those continuing to the next(D with Bt).

Table 2 provides further information about newand departing clients and allows an understandingof long-term trends. Specifically, we provideevidence on whether the new clients are from Big 4or Small firms (small auditing firms) or othersources. Similarly we provide evidence on whetherdeparting clients go to Big 4 or Small firms, ordepart for other reasons. Table 2 Panel A shows thesource of new clients. Note that the biggest sourceof new clients for the Second Tier firms is the Big 4(256 firms, or 60 percent). However, there is steadytapering off of clients from the Big 4. While therewere 106 new clients from the Big 4 in 2005, there

were only 41 in 2008. This is consistent with asettling down of the effects of SOX and Andersen.

Table 2 Panel B shows information concerningdeparting clients. In addition to client departuresto the Big 4 and Small firms, departures mayalso be induced by bankruptcy, mergers andacquisitions (M&A) or deregistration. The twobiggest categories are departures to Small firmsand departures because of deregistration; theseaccount for almost three-quarters of all departures.Our result confirms the post-SOX pattern ofderegistration (e.g., Leuz, Triantis & Wang, 2008). Atotal of 148 firms (35 percent of departing clients)deregistered during the sample period. We alsonote that the post-SOX deregistration movementappears to have peaked in 2007 (51 percent). Otherthan deregistration, departure of clients to Smallfirms is a major category (160 firms, or 38 percent).

For this sample of Second Tier clients (organizedby client years), we obtain various risk/characteristic variables. Following the priorliterature, we obtain six traditional risk variables asfollows: Assets: total assets in millions (Data6) Leverage: ratio of total liabilities to total assets

(Data181/Data6) ROA: return on assets (Data18/Data6)

Table 2: Further analysis of new and departing clients

Panel A: Sources of new clients

2005 2006 2007 2008 Total

Count % Count % Count % Count % Count %

Big 4 106 81% 56 58% 53 50% 41 44% 256 60%Small firms 14 11% 16 17% 38 36% 30 32% 98 23%Unknown 11 8% 24 25% 14 13% 23 24% 72 17%Total 131 100% 96 100% 105 100% 94 100% 426 100%

Panel B: Destinations of departing clients

2004 2005 2006 2007 Total

Count % Count % Count % Count % Count %

Big 4 7 6% 7 6% 16 15% 10 11% 40 10%Small firms 47 43% 44 39% 46 44% 23 25% 160 38%Bankruptcy 1 1% 0 0% 5 5% 3 3% 9 2%

M&A 13 12% 19 9% 6 6% 5 5% 43 10%Deregistered 38 35% 36 32% 27 26% 47 51% 148 35%Unknown 4 4% 8 14% 4 4% 4 4% 20 5%Total 110 100% 114 100% 104 100% 92 100% 420 100%

Note: This table categorizes new and departing clients. New unknown clients include recently registered firms.For a description of the sample, see Table 1.




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Table 3: New versus continuing clients

Variables Continuing clients All new clients New from Big 4 New from small firms

Mean Mean Mean Mean(median) (median) (median) (median)

Assets 308.74 414.20** 379.96 241.12(86.08) (136.49)*** (143.96)*** (60.99)

Leverage 0.67 0.55 0.52 0.60(0.44) (0.49)* (0.46) (0.48)

ROA -0.17 -0.10 -0.07 -0.22(0.01) (0.00) (0.01) (-0.03)***

Loss 0.46 0.48 0.44 0.62***(0.00) (0.00) (0.00) (1.00)***

ARInv 0.30 0.29 0.28 0.29(0.27) (0.24) (0.23) (0.24)

DSales 32.60 40.31 12.45 118.99(8.31) (11.42)** (7.16) (15.70)**

ICW_302[0] 0.29 0.33 0.39*** 0.34(0.00) (0.00) (0.00)*** (0.00)

ICW_302[-1] 0.30 0.26 0.32 0.23

(0.00) (0.00) (0.00) (0.00)ICW_404[0] 0.06 0.10*** 0.13*** 0.08(0.00) (0.00)*** (0.00)*** (0.00)

ICW_404[-1] 0.07 0.17*** 0.20*** 0.15***(0.00) (0.00)*** (0.00)*** (0.00)***

ICW_404COMP[-1] 0.02 0.05*** 0.08*** 0.03(0.00) (0.00)*** (0.00)*** (0.00)

RST_Exante[0] 0.06 0.06 0.06 0.07(0.00) (0.00) (0.00) (0.00)

RST_Exante[-1] 0.11 0.18*** 0.17*** 0.19**(0.00) (0.00)*** (0.00)*** (0.00)**

RST_Exante_CoreErn[-1] 0.05 0.09*** 0.10*** 0.12***(0.00) (0.00)*** (0.00)*** (0.00)***

RST_Exante_Neg[-1] 0.06 0.13*** 0.13*** 0.15***(0.00) (0.00)*** (0.00)*** (0.00)***

RST_Expost[0] 0.07 0.09* 0.10* 0.10(0.00) (0.00)* (0.00)* (0.00)

RST_Expost[-1] 0.13 0.17** 0.16*** 0.15(0.00) (0.00)** (0.00)*** (0.00)

RST_Expost_CoreErn[-1] 0.05 0.09*** 0.10*** 0.09*(0.00) (0.00)*** (0.00)*** (0.00)*

RST_Expost_Neg[-1] 0.07 0.13*** 0.14*** 0.13**(0.00) (0.00)*** (0.00)*** (0.00)**

N 2036 426 256 98

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively.Note: We use the two-sample t-test to test the differences in mean and the Wilcoxon rank sum test to test the differencesin median. Variables are defined as follows:

Assets: total assets in millions (Data6)Leverage: ratio of total liabilities to total assets (Data181/Data6)ROA: return on assets (Data18/Data6)Loss: binary variable, equals 1 if ROA < 0, and 0 otherwise

ARInv: ratio of accounts receivable and inventory to total assets (Data2 + Data3)/(Data6)DSales: percentage change in sales from prior yearICW_302[period]: if a weakness pursuant to SOX Section 302 is disclosed for the periodICW_404[period]: if a weakness pursuant to SOX Section 404 is disclosed for the periodICW_404COMP[period] : if three or more weaknesses pursuant to SOX Section 404 is disclosed for the periodRST_Exante[period]: if earnings for the period is eventually restatedRST_Exante_CoreErn[period] : if core earnings for the period is eventually restatedRST_Exante_Neg[period]: if earnings for the period is eventually restated and negativeRST_Expost[period]: if there is a restatement during the periodRST_Expost_CoreErn[period]: if the restatement involves core earningsRST_Expost_Neg[period]: if the restatement decreases earnings.




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for new clients. Severity variables such asICW_404COMP[-1] and RST_Exante_Neg[-1]indicate similar results, that is, new firms are riskierthan continuing firms. We also note that the resultsfor all new clients are substantially similar to thosefor new firms fromthe Big 4 only as well as to thosefor new firms from the small firms only. Somenuances indicated by the subsample analysis: new

clients from small auditing firms are not larger thancontinuing clients and have lower ROA and higherLoss; new clients from the Big 4 have morepronounced ICW.

Table 4 provides a comparison of departingclients with continuing clients. Among thetraditional risk variables, we note that with theexception of ARInv, the rest are significant.

Table 4: Departing versus continuing clients

Variables Continuing clients

All departingclients

Departto Big 4

Depart tosmall firms

Mean Mean Mean Mean

(median) (median) (median) (median)Assets 263.57 149.10*** 527.47** 34.52***

(78.48) (35.45)*** (102.79) (15.38)***Leverage 0.61 1.87*** 0.51 3.69***

(0.42) (0.55)*** (0.39) (0.64)***ROA -0.15 -0.63*** -0.16 -1.43***

(0.01) (-0.04)*** (-0.03) (-0.16)***Loss 0.45 0.59*** 0.60* 0.68***

(0.00) (1.00)*** (1.00)* (1.00)***ARInv 0.30 0.31 0.24* 0.31

(0.27) (0.29) (0.23) (0.29)DSales 35.74 197.95** 17.48 504.00***

(9.90) (5.10)*** (14.75) (2.91)***ICW_302[0] 0.30 0.30 0.35 0.36*

(0.00) (0.00) (0.00) (0.00)*ICW_302[-1] 0.22 0.27** 0.33 0.32***

(0.00) (0.00)** (0.00) (0.00)***ICW_404[0] 0.08 0.05* 0.13 0.04

(0.00) (0.00)* (0.00) (0.00)ICW_404[-1] 0.07 0.05 0.15* 0.03**

(0.00) (0.00) (0.00)* (0.00)**ICW_404COMP[-1] 0.03 0.01 0.03 0.01

(0.00) (0.00) (0.00) (0.00)RST_Exante[0] 0.09 0.05** 0.05 0.05*

(0.00) (0.00)** (0.00) (0.00)*RST_Exante[-1] 0.12 0.16** 0.15 0.19***

(0.00) (0.00)** (0.00) (0.00)***RST_Exante_CoreErn[-1] 0.06 0.06 0.03 0.08

(0.00) (0.00) (0.00) (0.00)

RST_Exante_Neg[-

1] 0.07 0.09 0.08 0.08(0.00) (0.00) (0.00) (0.00)RST_Expost[0] 0.11 0.07** 0.08 0.08

(0.00) (0.00)** (0.00) (0.00)RST_Expost[-1] 0.12 0.16* 0.15 0.17*

(0.00) (0.00)* (0.00) (0.00)*RST_Expost_CoreErn[-1] 0.06 0.07 0.03 0.09*

(0.00) (0.00) (0.00) (0.00)*RST_Expost_Neg[-1] 0.07 0.09 0.05 0.11

(0.00) (0.00) (0.00) (0.00)N 2036 420 40 160

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively.Note: We use the two-sample t-test to test the differences in mean and the Wilcoxon rank sum test to test thedifferences in median. For variable definitions, see Table 3.




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Departing clients are smaller, have greaterleverage, lower profits (lower ROA and higherLoss) and lower (median) change in sales. Turing

to ICW, we note that ICW_302[-1] is significantlyhigher for departing clients overall, whileICW_404[-1] is lower mainly for clients departingto smaller auditing firms. The lack of a strongfinding concerning ICW_404[-1] is probablyexplained by the threshold for Section 404reporting: many departing clients are probablynon-accelerated filers. Finally, we note thatrestatement risk is higher for departing clients. Forexample, RST_Exante[-1] is 0.12 for continuingfirms and 0.16 for departing firms; this result isstronger if one considers clients departing to smallfirms (value is 0.19). While there is some evidencethat departing clients have higher restatementand ICW risks in terms of prevalence of theserisks, there is almost no evidence that severity isgreater.

The univariate tests suggest strong support forhypothesis 1 (new versus continuing clients) as wellas moderate support for hypothesis 2 (departingversus continuing clients). But more conclusiveresults are only possible using multivariate analysis.Before presenting our multivariate results, weprovide evidence of correlations among restatementand ICW variables in Table 5. We note significantcorrelations between various specifications ofthe restatement and ICW variables. For example,ICW_302[-1] has correlations of 0.38, 0.19 and0.27 with ICW_404[-1], RST_Exante[-1] andRST_Expost[-1], respectively; all values arestatistically significant. This is consistent with theobservation that restatement and ICW variables arein some general sense related to the auditing riskenvironment of client firms. Because of these highcorrelations, although they do not meet the

threshold for inducing severe multi-collinearityproblems, we choose to run cross-sectional models(reported below) using restatement and ICW

variables one at a time.Our key results concerning hypotheses 1 and

2 are found in Tables 6 and 7. We use logisticregressions as in the prior literature on auditorswitching to determine the importance ofrestatement and ICW variables in explainingswitches to and from the Second Tier. Table 6provides a comparison of (all) new and continuingclients. Table 7 provides a comparison of (all)departing and continuing clients.

Table 6 Panel A focuses on ICW. Model 6A1 isthe base model in which only traditional risk (thatis, control) variables are used. In subsequentmodels, ICW variables are added to evaluate theirexplanatory power. The R2 in these models rangefrom 0.026 (model 6A1, the base model) to 0.045(model 6A3 containing ICW_404[-1]). Amongcontrol variables, only two, LnAssets and Loss,appear to be significantly related to auditorswitches. New clients, compared to continuingclients, are larger and are more likely to beloss-making. Turning to ICW, we note that thecoefficient of ICW_404[-1] is significantly positivein model 6A3 indicating that the prevalence of ICWis associated with switches to the Second Tier.Additionally, in model 6A4, we find that severitymatters: the coefficient of ICW_404COMP[-1] issignificantly positive.

Table 6 Panels B and C focus on restatements,the former using ex-ante measures and the latterex-post. The base model is 6A1 and it is not repeatedin these panels. The range of R2 values in Panels Band C are similar to that of Panel A. Overall, thereis strong evidence that the prevalence ofrestatement is associated with switches into the

Table 5: Pearson correlation for internal control and restatement variables

A B C D E F G H I

A. ICW_302[-1] 1 0.38 0.25 0.19 0.15 0.15 0.27 0.18 0.19B. ICW_404[-1] 1 0.55 0.20 0.16 0.16 0.22 0.16 0.17C. ICW_404COMP[-1] 1 0.11 0.09 0.08 0.12 0.10 0.09D. RST_Exante[-1] 1 0.64 0.75 0.62 0.47 0.53E. RST_Exante_CoreErn[-1] 1 0.75 0.48 0.74 0.56F. RST_Exante_Neg[-1] 1 0.53 0.55 0.72G. RST_Expost[-1] 1 0.65 0.75H. RST_Expost_CoreErn[-1] 1 0.76I. RST_Expost_Neg[-1] 1

Note: Significant values (i.e., p < 0.01) are in bold. For variable definitions, see Table 3.




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Table 6: Logistic regressions of new clients compared to continuing clients

Panel A: Internal control weakness

Variable Model 6A1 Model 6A2 Model 6A3 Model 6A4

Intercept -2.82*** -2.80*** -2.76*** -2.80***(140.49) (138.77) (132.22) (137.55)

LnAssets 0.22*** 0.22*** 0.19*** 0.21***(34.10) (35.07) (24.50) (31.23)

Leverage -0.03 -0.03 -0.01 -0.03(0.15) (0.16) (0.02) (0.15)

ROA -0.02 -0.02 0.00 -0.02(0.03) (0.04) (0.00) (0.03)

Loss 0.25** 0.27** 0.18 0.22(4.07) (4.90) (2.17) (3.23)

ARInv 0.25 0.26 0.24 0.25(0.89) (0.98) (0.86) (0.88)

DSales 0.00 0.00 0.00 0.00(0.14) (0.17) (0.22) (0.18)

ICW_302[-1] -0.17

(1.87)ICW_404[-1] 0.86***

(28.97)ICW_404COMP[-1] 0.82***

(9.56)

Pseudo-R2 0.026 0.027 0.045 0.032N(total) 2365 2365 2365 2365N(new) 392 392 392 392N(continuing) 1973 1973 1973 1973

Panel B: Restatements ex ante

Variable Model 6B1 Model 6B2 Model 6B3

Intercept -2.87*** -2.87*** -2.86***

(144.02) (143.25) (142.55)LnAssets 0.22*** 0.22*** 0.22***(33.75) (33.67) (32.62)

Leverage -0.05 -0.04 -0.05(0.28) (0.23) (0.29)

ROA -0.03 -0.01 -0.02(0.07) (0.01) (0.02)

Loss 0.22* 0.25** 0.23*(3.27) (4.15) (3.58)

ARInv 0.23 0.26 0.24(0.81) (0.98) (0.84)

DSales 0.00 0.00 0.00(0.18) (0.16) (0.18)

RST_Exante[-1] 0.55***(13.30)

RST_Exante_CoreErn[-

1] 0.76***(14.19)RST_Exante_Neg[-1] 0.80***

(20.15)

Pseudo-R2 0.035 0.035 0.039N(total) 2365 2365 2365N(new) 392 392 392N(continuing) 1973 1973 1973




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Second Tier. In model 6B1, we find that thecoefficient of RST_Exante[-1] is significantlypositive. Similarly, in model 6C1, we find that thecoefficient of RST_Expost[-1] is significantlypositive. In addition to these results concerning theprevalence of restatements, we also note that clientsswitching to the Second Tier are more likely tohave severe restatements. In models 6B26B3and 6C26C3, we find that the coefficients of thecore earnings and negative restatement variables(in the ex-ante as well as the ex-post specifications)are significantly positive. Thus, clients switchingto the Second Tier are more likely to haverestatements that involve core accounts anddecrease earnings. Overall, the evidence in Table 6supports hypothesis 1.16,17

Table 7 compares departing firms withcontinuing firms. In general, the R2 values arehigher in this table than in Table 6. To calibrateour results, as in Table 6, we start with the basemodel 7A1. This base model indicates that clients

departing from the Second Tier tend to be smallerfirms, with greater losses and with greaterleverage. Thus, riskier firms, at least from atraditional auditing risk perspective, are departing.Panel A evaluates the ICW risk of departing firmsversus continuing firms. As expected, we find thatthe coefficient of ICW_302[-1] is significantlypositive (model 7A2). However, because departingfirms are smaller firms (recall that the coefficientof LnAssets is significantly negative) with a higherlikelihood of being non-accelerated filers, ICW_404variables are insignificant (models 7A3 and 7A4).

Table 7 Panels B and C show the associationbetween restatement risk and departures from theSecond Tier, the former using ex-ante measures andthe latter ex-post. The range of R2 values in Panel Bis similar to that of Panel A. Overall, there isstrong evidence that the prevalence of restatementis associated with switches out of the Second Tier.In model 7B1, we find that the coefficient ofRST_Exante[-1] is significantly positive. Similarly,

Table 6: Continued

Panel C: Restatements ex post

Variable Model 6C1 Model 6C2 Model 6C3

Intercept -2.84*** -2.85*** -2.85***(141.96) (142.12) (142.01)

LnAssets 0.22*** 0.22*** 0.22***(33.00) (33.70) (32.53)

Leverage -0.04 -0.04 -0.05(0.24) (0.19) (0.40)

ROA -0.02 -0.02 -0.02(0.03) (0.02) (0.03)

Loss 0.23* 0.24* 0.22*(3.41) (3.69) (3.08)

ARInv 0.24 0.25 0.23(0.87) (0.92) (0.80)

DSales 0.00 0.00 0.00(0.18) (0.16) (0.18)

RST_Expost[-1] 0.36**

(5.82)RST_Expost_CoreErn[-1] 0.57***

(7.80)RST_Expost_Neg[-1] 0.80***

(20.72)

Pseudo-R2 0.030 0.031 0.039N(total) 2365 2365 2365N(new) 392 392 392N(continuing) 1973 1973 1973

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively.Note: This table presents the logit regression results for new firms to the Second Tier versus continuing clients.The dependent variable equals 1 when the client is new and 0 when continuing. The chi-square statistics arereported in parentheses. For variable definitions, see Table 3.




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Table 7: Logistic regression analyses of departing clients compared to continuing clients



Intercept -1.02*** -1.00*** -1.02*** -1.04***(21.04) (20.37) (21.01) (21.66)

LnAssets -0.23*** -0.24*** -0.22*** -0.22***(33.71) (36.85) (32.09) (31.89)

Leverage 0.12** 0.12** 0.12** 0.12**(5.65) (5.38) (5.65) (5.72)

ROA 0.11 0.11 0.11 0.11(2.48) (2.58) (2.47) (2.47)

Loss 0.38*** 0.34*** 0.38*** 0.39***(9.62) (7.57) (9.63) (10.09)

ARInv 0.24 0.21 0.24 0.25(0.88) (0.62) (0.88) (0.90)

DSales 0.00 0.00 0.00 0.00(1.59) (1.66) (1.59) (1.59)

ICW_302[-1] 0.31**

(5.86)ICW_404[-1] -0.04

(0.03)ICW_404COMP[-1] -0.43

(0.94)

Pseudo-R2 0.060 0.064 0.060 0.061N(total) 2366 2366 2366 2366N(departing) 401 401 401 401N(continuing) 1965 1965 1965 1965



Intercept -1.03*** -1.02*** -1.02***

(21.36) (21.12) (20.99)LnAssets -0.23*** -0.23*** -0.23***(34.86) (33.97) (34.57)

Leverage 0.12** 0.12** 0.12**(5.18) (5.60) (5.42)

ROA 0.10 0.11 0.11(2.12) (2.50) (2.49)

Loss 0.36*** 0.38*** 0.37***(8.41) (9.50) (9.11)

ARInv 0.23 0.24 0.24(0.77) (0.86) (0.83)

DSales 0.00 0.00 0.00(1.33) (1.60) (1.61)

RST_Exante[-1] 0.36**(5.38)


1] 0.18(0.60)RST_Exante_Neg[-1] 0.31

(2.32)

Pseudo-R2 0.064 0.060 0.062N(total) 2366 2366 2366N(departing) 401 401 401N(continuing) 1965 1965 1965




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in model 7C1, we find that the coefficient ofRST_Expost[-1] is significantly positive. In additionto these results concerning the prevalence ofrestatements, we provide results concerning theirseverity. We note weaker results in this regard. Inmodel 7C3, we note a significant coefficient forRST_Expost_Neg[-1], but this is the only significantvariable among severity variables. Principallybecause of the significance of prevalence measures(of ICW and restatements), we conclude that ourresults are supportive of hypothesis 2.18

Tables 8 and 9 provide further evidence onhypotheses 1 and 2. Here, we focus on the keysubsets of new and departing clients: new from theBig 4 (Table 8) and departing to small auditingfirms (Table 9).

Results in Table 8 (new from the Big 4 versuscontinuing) are similar to those reported earlier inTable 6 (all new clients versus continuing). The R2

values and the behavior of controls are roughlycomparable. With regard to controls, we again find

that new firms tend to be larger than continuingfirms. However, in Table 8, we do not find thecoefficient of Loss to be significant; instead, wefind that the coefficient of DSales is positive andmarginally significant. Results concerning ICWand restatements are largely the same. New clientsfrom the Big 4 have greater companywide ICW.Also, new clients have a greater prevalence ofrestatements (coefficients of both RST_Exante[-1]and RST_Expost[-1] are significantly positive) andthere is also strong indication that new clients havegreater levels of severe restatements.

Table 9 reports the comparison between clientsdeparting to small auditing firms and continuingclients. These results are similar to those reportedearlier in Table 7. As in Table 7, we find thatthe coefficienst of ICW_302[-1], RST_Exante[-1]and RST_Expost[-1] are significantly positive,indicating the prevalence of these risk factors. Adifference is that restatement variables (especiallyin Panel C) show greater levels of significance.

Table 7: Continued



Intercept -1.02*** -1.02*** -1.02***(20.94) (21.21) (21.11)

LnAssets -0.23*** -0.23*** -0.23***(35.46) (34.30) (34.74)

Leverage 0.12** 0.12** 0.12**(5.15) (5.61) (5.07)

ROA 0.11 0.11 0.11(2.55) (2.53) (2.46)

Loss 0.36*** 0.37*** 0.37***(8.71) (9.24) (9.07)

ARInv 0.23 0.24 0.24(0.79) (0.85) (0.89)

DSales 0.00 0.00 0.00(1.62) (1.60) (1.61)

RST_Expost[-1] 0.32**

(4.25)RST_Expost_CoreErn[-1] 0.33

(2.33)RST_Expost_Neg[-1] 0.34*

(2.94)

Pseudo-R2 0.063 0.062 0.062N(total) 2366 2366 2366N(departing) 401 401 401N(continuing) 1965 1965 1965

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively.Note: This table presents logit regression results for clients departing from the Second Tier versus continuingclients. The dependent variable equals 1 when the client is departing and 0 when continuing. The chi-squarestatistics are reported in parentheses. For variable definitions, see Table 3.




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Table 8: Logistic regressions analyses of new Big 4 clients compared to continuing clients



Intercept -2.96*** -2.97*** -2.92***(99.04) (99.12) (92.24) -2.93***

LnAssets 0.22*** 0.22*** 0.18*** (94.90)(21.39) (20.66) (14.18) 0.21***

Leverage -0.18 -0.18 -0.10 (18.16)(1.08) (1.06) (0.41) -0.17

ROA 0.13 0.14 0.19 (0.95)(0.22) (0.25) (0.56) 0.12

Loss 0.12 0.11 0.04 (0.19)(0.58) (0.42) (0.05) 0.07

ARInv -0.19 -0.20 -0.20 (0.17)(0.33) (0.37) (0.34) -0.21

DSales 0.00* 0.00* 0.00* (0.40)(3.63) (3.62) (3.56) 0.00*

ICW_302[-1] 0.11 (3.27)

(0.52)ICW_404[-1] 0.99***

(28.81)ICW_404COMP[-1] 1.14***

(16.57)

Pseudo-R2 0.031 0.031 0.053 0.043N(total) 2221 2221 2221 2221N(new Big 4) 248 248 248 248N(continuing) 1973 1973 1973 1973



Intercept -3.02*** -3.01*** -2.99***

(100.90) (100.24) (99.56)LnAssets 0.22*** 0.22*** 0.22***(21.07) (20.66) (20.14)

Leverage -0.21 -0.21 -0.21(1.38) (1.37) (1.37)

ROA 0.14 0.15 0.15(0.26) (0.29) (0.27)

Loss 0.11 0.14 0.12(0.43) (0.69) (0.56)

ARInv -0.20 -0.18 -0.20(0.37) (0.29) (0.34)

DSales 0.00* 0.00* 0.00*(3.79) (3.81) (3.72)

RST_Exante[-1] 0.59***(10.50)


1] 0.86***(13.18)RST_Exante_Neg[-1] 0.78***

(13.26)

Pseudo-R2 0.039 0.041 0.041N(total) 2221 2221 2221N(new Big 4) 248 248 248N(continuing) 1973 1973 1973




13/17

Our final table, Table 10, presents evidence onhypothesis 3. Although hypothesis 3 pertains to thedeparting versus continuing as well as the newversus continuing comparisons, because of spaceconstraints we chose to focus on the new versuscontinuing comparisons. Also, for the same reason,we report prevalence measures only. Panel Acompares the dismissals sample of new firmswith continuing firms and Panel B compares theresignations sample of new firms with continuingfirms. Significantly, we note that Panel A contains85 resignations and Panel B contains 248 dismissals:the new clients of the Second Tier are more likelyto have dismissed their auditors. According tohypothesis 3, restatement and ICW risks are morepronounced in the resignations rather than thedismissals sample. We do not find evidenceconsistent with this hypothesis. Both the dismissalsand resignations samples show similar levels ofsignificance for the restatement and ICW variables.For example, in both Panels A and B, we find that

ICW_404[-1], RST_Exante[-1] and RST_Expost[-1]are significant. We do, however, note that themagnitude of the coefficients are greater in Panel Aconsistent with the hypothesis. In Panel C, we run adirect comparison of resignations with dismissals.Resignation firms are significantly smaller andthere is no indication that their restatement andICW risks are potentially higher. This is consistentwith results reported in Panels A and B that bothresignations and dismissals show sensitivity torestatement and ICW.

5. DISCUSSION AND CONCLUSION

The Post-SOX era coincides with the rise of theSecond Tier auditing firms. Since many of theirnew clients are large firms from the Big 4, and sincelarge firms are assumed to carry higher level oflitigation risks with them, regulators have beenconcerned about client portfolio risks of the SecondTier. An earlier and influential study, Hogan and

Table 8: Continued



Intercept -3.00*** -3.00*** -3.00***(100.24) (100.19) (100.11)

LnAssets 0.22*** 0.22*** 0.22***(20.50) (20.91) (20.33)

Leverage -0.20 -0.20 -0.22(1.33) (1.29) (1.45)

ROA 0.14 0.14 0.14(0.24) (0.25) (0.23)

Loss 0.10 0.11 0.10(0.41) (0.48) (0.39)

ARInv -0.19 -0.19 -0.19(0.31) (0.31) (0.33)

DSales 0.00* 0.00* 0.00*(3.54) (3.68) (3.61)

RST_Expost[-1] 0.48***


(9.90)RST_Expost_Neg[-1] 0.85***

(16.97)

Pseudo-R2 0.036 0.038 0.044N(total) 2221 2221 2221N(new Big 4) 248 248 248N(continuing) 1973 1973 1973

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively.Note: This table presents the logit regression results for new firms from the Big 4 versus continuing clients. Thedependent variable equals 1 when the client is a new from the Big 4 and 0 when continuing. The chi-squarestatistics are reported in parentheses. For variable definitions, see Table 3.




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Table 9: Logistic regression analyses of departing clients to small firms compared to continuing clients



Intercept -0.48 -0.41 -0.50 -0.48(2.08) (1.54) (2.23) (2.03)

LnAssets -0.65*** -0.70*** -0.65*** -0.66***(92.90) (103.36) (86.97) (90.95)

Leverage 0.03 0.03 0.03 0.03(0.54) (1.03) (0.52) (0.54)

ROA 0.15* 0.16* 0.14* 0.15*(3.16) (3.53) (3.13) (3.16)

Loss 0.33 0.23 0.34 0.32(2.56) (1.23) (2.70) (2.51)

ARInv 0.19 0.02 0.19 0.19(0.23) (0.00) (0.22) (0.23)

DSales 0.00 0.00 0.00 0.00(1.97) (2.47) (1.97) (1.97)

ICW_302[-1] 0.81***

(16.35)ICW_404[-1] -0.28

(0.28)ICW_404COMP[-1] 0.09

(0.01)

Pseudo-R2 0.181 0.198 0.182 0.181N(total) 2117 2117 2117 2117N(depart to SF) 152 152 152 152N(continuing) 1965 1965 1965 1965



Intercept -0.48 -0.47 -0.47

(2.02) (1.99) (2.02)LnAssets -0.67*** -0.66*** -0.66***(95.35) (93.43) (93.73)

Leverage 0.03 0.03 0.03(0.64) (0.60) (0.61)

ROA 0.14 0.15* 0.15*(2.53) (3.26) (3.22)

Loss 0.27 0.31 0.31(1.72) (2.34) (2.30)

ARInv 0.12 0.17 0.17(0.09) (0.19) (0.18)

DSales 0.00 0.00 0.00(1.58) (2.00) (1.99)

RST_Exante[-1] 0.74***(9.91)


1] 0.57*(2.76)RST_Exante_Neg[-1] 0.37

(1.28)

Pseudo-R2 0.191 0.184 0.183N(total) 2117 2117 2117N(depart to SF) 152 152 152N(continuing) 1965 1965 1965




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Martin (2009), evaluates the new and departingclients of the Second Tier against continuing clientsand finds that: (a) new clients, especially those fromthe Big 4 bring in additional risks mostly because oftheir larger size, and (b) these risks are somewhatoffset by the movement of other risky clients fromthe Second Tier to other auditors. But this earlierstudy, because of its sampling period, was unable toadequately assess the importance of restatementand ICW risks. Our study fills this void. Weexplicitly formulate hypotheses relating theswitching behavior of the Second Tier to these newrisk factors and test the hypotheses using a samplethat fully exploits the restatement and ICWdisclosures in the post-SOX era.

We show that the new clients of the SecondTier have higher prevalence and severity ofrestatements and ICW. This has two implications.First, this implies that the new clients acquired bythe Second Tier are in some sense riskier thanimplied by an analysis of the traditional variables

used in the literature. Second, we contribute tothe large literature on auditor switching bydemonstrating the importance of restatement andICW risks. We argue that restatement and ICWmeasures are indicators of a perturbed auditingenvironment, which poses additional risks to theauditor. Thus, traditional variables like firm size,ROA, loss, accounts receivables and inventory maynot fully explain audit risk.

We also show that departing clients of the SecondTier are somewhat riskier than continuing firms.The comparison of all departing and continuingfirms shows some evidence of differences in risk;however, more risks are evident in the subset offirms departing to small auditors. Combined withthe observation that the number of clients of theSecond Tier has held steady in the post-SOX era,this appears to indicate a somewhat deliberatestrategy on the part of the Second Tier to build theirclientele and manage risks prudently. Our samplespans a number of years in the post-SOX era and

Table 9: Continued



Intercept -0.47 -0.48 -0.49(2.04) (2.04) (2.15)

LnAssets -0.67*** -0.67*** -0.67***(97.48) (93.88) (96.13)

Leverage 0.03 0.03 0.03(1.02) (0.59) (1.00)

ROA 0.15* 0.15* 0.15*(3.38) (3.29) (3.36)

Loss 0.29 0.31 0.31(2.05) (2.23) (2.24)

ARInv 0.15 0.18 0.19(0.14) (0.20) (0.22)

DSales 0.00 0.00 0.00(2.01) (1.99) (1.99)

RST_Expost[-1] 0.66***


(6.84)RST_Expost_Neg[-1] 0.67**

(5.11)

Pseudo-R2 0.189 0.188 0.186N(total) 2117 2117 2117N(depart to SF) 152 152 152N(continuing) 1965 1965 1965

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively.Note: This table presents logit regression results for clients departing to small firms versus continuing clients. Thedependent variable equals 1 when the client is departing to small firms and 0 when continuing. The chi-squarestatistics are reported in parentheses. For variable definitions, see Table 3.




16/17

Table 10: Resignations versus dismissals

Panel A: New clients whose auditors resigned versus continuing clients

Variable Model 10A1 Model 10A2 Model 10A3 Model 10A4 Model 10A5

Intercept -2.99*** -2.99*** -2.80*** -3.07*** -3.03***(42.06) (42.03) (35.71) (43.26) (42.47)

LnAssets -0.02 -0.02 -0.09 -0.02 -0.02(0.04) (0.08) (1.27) (0.06) (0.09)

Leverage -0.18 -0.18 -0.13 -0.22 -0.20(0.72) (0.72) (0.51) (0.93) (0.84)

ROA -0.03 -0.02 0.00 -0.04 -0.03(0.01) (0.01) (0.00) (0.04) (0.01)

Loss 0.26 0.23 0.13 0.22 0.23(1.09) (0.85) (0.27) (0.81) (0.83)

ARInv -0.39 -0.43 -0.43 -0.42 -0.40(0.51) (0.59) (0.60) (0.58) (0.54)

DSales 0.00 0.00 0.00 0.00 0.00(0.01) (0.01) (0.00) (0.01) (0.01)

ICW_302[-1] 0.17(0.51)

ICW_404[-1] 1.39***(23.89)

RST_Exante[-1] 0.83***(9.31)

RST_Expost[-1] 0.62**(5.12)

Pseudo-R2 0.006 0.006 0.039 0.019 0.013N(total) 2058 2058 2058 2058 2058N(resign) 85 85 85 85 85N(continuing) 1973 1973 1973 1973 1973

Panel B: New clients who dismissed their auditors versus continuing clients

Variable Model 10B1 Model 10B2 Model 10B3 Model 10B4 Model 10B5

Intercept -3.30*** -3.30*** -3.25*** -3.36*** -3.33***

(127.02) (126.49) (119.66) (129.50) (128.02)LnAssets 0.22*** 0.23*** 0.19*** 0.23*** 0.22****

(24.09) (24.11) (17.15) (24.30) (23.61)Leverage -0.03 -0.03 0.00 -0.04 -0.04

(0.09) (0.09) (0.00) (0.14) (0.13)ROA -0.04 -0.04 -0.01 -0.05 -0.04

(0.06) (0.06) (0.01) (0.08) (0.06)Loss 0.20 0.21 0.13 0.18 0.19

(1.84) (1.86) (0.76) (1.47) (1.53)ARInv 0.29 0.29 0.28 0.29 0.30

(0.82) (0.84) (0.75) (0.82) (0.86)DSales 0.00 0.00 0.00 0.00 0.00

(0.12) (0.12) (0.19) (0.15) (0.14)ICW_302[-1] -0.03

(0.03)ICW_404[-1] 0.93***

(24.46)RST_Exante[-1] 0.49***

(6.92)RST_Expost[-1] 0.33*

(3.22)

Pseudo-R2 0.023 0.023 0.042 0.028 0.026N(total) 2221 2221 2221 2221 2221N(dismiss) 248 248 248 248 248N(continuing) 1973 1973 1973 1973 1973




17/17

therefore our results do not just indicate animmediate reaction to Andersen and SOX. Rather,our results seem indicative of a longer-term trendin the auditing market where the Second Tier isgaining market share in a steady and deliberatefashion. This conclusion is also supported by ourresults concerning resignations and dismissals. Notonly do we find that most of the switches to theSecond Tier are dismissals rather than resignations(that is, in most cases, the auditor is fired), we alsofind that the sensitivities of switches to restatementand ICW risks are no different between theresignation and dismissal samples.

NOTES

1. The GAO report, dated January 2008 (GAO,2008), identifies several constraints faced by

Second-Tier firms including: (a) the abilityto hire and retain employees, (b) lack ofreputation, (c) lack of capabilities in multiplecountries to service multinationals, and (d) theability to deal with the litigation risk arisingfrom large clients.

2. A report issued by Audit Analytics in February2009 entitled 2008 Financial Restatements:An Eight Year Comparison indicates a sharprise in the number of restatements during20052006. While the level is also quite high in2007, it represents a fall from 2006. An evenlower level of restatements in 2008 may suggesta trend. Overall, our sample period has a highnumber of restatements.

3. There is also a stream of papers that solely focuson restatements and provide insights for theauditing context. For example, Abbott, Parker

Table 10: Continued

Panel C: Resignations versus dismissals of new clients

Variable Model 10C1 Model 10C2 Model 10C3 Model 10C4 Model 10C5

Intercept 0.46 0.47 0.53 0.39 0.43(0.67) (0.71) (0.88) (0.48) (0.57)

LnAssets -0.29*** -0.30*** -0.32*** -0.29*** -0.29****(7.97) (8.49) (9.05) (7.84) (8.12)

Leverage -0.17 -0.18 -0.16 -0.24 -0.22(0.30) (0.35) (0.27) (0.57) (0.48)

ROA 0.10 0.12 0.15 0.06 0.07(0.03) (0.05) (0.08) (0.01) (0.02)

Loss 0.11 0.07 0.06 0.10 0.09(0.11) (0.05) (0.04) (0.09) (0.08)

ARInv -0.62 -0.57 -0.59 -0.59 -0.61(0.93) (0.74) (0.82) (0.81) (0.88)

DSales 0.00 0.00 0.00 0.00 0.00(0.04) (0.03) (0.01) (0.02) (0.02)

ICW_302[-1] 0.25(0.71)

ICW_404[-1] 0.43(1.62)

RST_Exante[-1] 0.43(1.79)

RST_Expost[-1] 0.39(1.44)

Pseudo-R2 0.056 0.059 0.063 0.064 0.062N(total) 333 333 333 333 333N(resign) 85 85 85 85 85N(dismiss) 248 248 248 248 248

*, **, and *** denote two-tailed significance at the 10, 5, and 1 percent levels, respectively.Note: This table presents results from logit regression. The dependent variable equals one if the client is a new clientof the Second Tier from the Big 4 or small firms and zero otherwise. We exclude new clients from unknown sincethey are mainly IPO firms. Panel A only includes new clients whose previous auditor resigned and Panel B only

includes new clients who dismissed their previous auditor. In Panel C, the dependent variable equals 1 if the auditorresigned and 0 if the auditor was dismissed from the Big 4 or small firms. The chi-square statistics are reported inparentheses. For variable definitions, see Table 3.



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